Economics and...

Saturday, April 29, 2006

Ran is awesome

I rented a DVD of Kurosawa’s Ran to watch on a flight from Boston to LA, and I have become once again restored in my flagging faith that the art of cinema can on occasion rise comfortably above the mediocre. Ran won the Oscar for best costume design, and in my mind it is the all time best in that category, as well as in art direction & set decoration (nominated but didn’t win), and possibly in cinematography as well (also nominated). I’m not one who is normally impressed with great costumes and sets, but this film is one of very few that could compete with the aerial view of the Rocky Mountains from my window seat. I was mesmerized from the very first scene. (Amy Taubin of the Village Voice described the film as “stunning”, and this is one of those occasions when I remember that the word is derived from an actual verb.)

Ran is an adaptation of Shakespeare’s King Lear, set in 16th century Japan. Kurosawa cuts and pastes a lot of elements from King Lear: for example, there is a character who has had his eyes gouged out, like Gloucester in Lear, but in Ran, the gouging happened long before the movie began, and his relationship to the lead character is quite different; and there is a non-fatal cliff jump, as in Lear (though in most productions the cliff is not even a real one), but in Ran, the blind character is not the one who jumps. Anyhow, the plot is secondary. It’s mostly about visuals. It reminded me of (and undoubtedly influenced) the recent Chinese film Hero, but I didn’t miss the supernatural martial arts tricks, and the presence of some emotional substance within the “visually spectacular Asian war film” genre is a distinct plus.

So now we have Ran, The Ox-Bow Incident, and Sunrise: A Song of Two Humans on my list of films that justify all the time spent watching mediocre films. I was beginning to wonder if the invention of color photography had contributed anything to the art of cinema. Now I see that it has – if you know where to look.

Sunday, April 23, 2006

A possible counterargument

In my last post, I argued that China, with its high growth rate, has a comparative advantage in producing future goods and therefore should be running a trade deficit rather than a surplus. If there is a counterargument to be made, it would probably rest on the distinction between average productivity and marginal productivity. China’s average productivity is quite low compared to what it will be in the future. However, if the marginal factory worker in China is someone who otherwise would be sitting on a farm twiddling his thumbs, then, on the margin, productivity might be extremely high. In other words, if we demand a few more manufactured goods from China, and they take some otherwise useless person and put him to work in a factory, they have increased industrial production without giving anything up anything else (except the worker’s leisure). In that extreme case, if we ignore the worker’s foregone leisure, the marginal productivity would be infinite: the quantity produced goes up by some positive amount, while the total social cost of production goes up by zero. In that case, obviously, on the margin, China has a huge comparative advantage in producing present goods rather than future goods.

Something like this argument seems to be behind claims that China’s weak-yuan policy is useful to help “manage industrialization”. As a Keynesian, I’m vaguely sympathetic, but I think this argument misses some critical points. By most accounts, China is industrializing too quickly already. If there are really people sitting on farms twiddling their thumbs, surely the Chinese can come up with other useful things for them to do besides making toys for Americans. For example, how about training more of them to be doctors and nurses, or having them build new medical facilities, so that Chinese people can have better health care? Surely, if they put their mind to it, the Chinese government could think of a lot of domestic improvements that could be made by their newly available labor.

Essentially, China today is outsourcing its fiscal policy to American consumers. The communists have become so enamored of capitalism that they want to do everything the capitalist way. Traditional Keynesian fiscal policy is too socialist for them.

Friday, April 21, 2006

The Prosaic Economics of Currency Manipulation

I’m going to toss the two-country, two-sector, two-period model to which I referred in earlier posts. The prose version of the argument about intertemporal comparative advantage turns out to be a lot simpler than what I said earlier.

Consider two countries, one still developing and the other already developed. Let’s call them the People’s Republic of Developing and the Developed States of America. They have two products, one called “current manufactured goods” and the other called “future manufactured goods”. Which country has the comparative advantage in producing future manufactured goods? If you recognize that developing countries tend to become rapidly more productive, while developed countries only slowly increase their already high productivity, it should be clear that the People’s Republic has the comparative advantage. Equivalently, the DSA has a comparative advantage in producing current manufactured goods. In the normal course of things, therefore, you would expect the DSA to sell current manufactured goods in exchange for future manufactured goods. In other words, the DSA should run a trade surplus, and the People’s Republic should run a trade deficit. (This is in fact the normal relationship between developing and developed countries and explains, for example, why superstar developing countries like South Korea used to run large trade deficits.)

So why is it that, in today’s world, the US runs a deficit, and China runs a surplus? Some might argue that it’s demographics. The US population is growing faster than China’s, so maybe the US actually has a comparative advantage in producing future goods. There are a couple of problems with this argument. First of all, both countries have a large nontradables sector which can employ the excess working population at any particular time, so it’s not as if all those extra workers in China today, or in the US in the future, will go to waste. Second, if you take into account both slower population growth and faster productivity growth, China’s total growth rate is still much faster than the US, and almost everyone expects that situation to continue for the foreseeable future.

A better explanation, I think, is that China is over-saving. Part of the reason for this over-saving is currency market intervention, whereby the People’s Bank of China saves newly minted money in the US. Part of the reason also is that taxes are too high, which forces Chinese people to save via their government. Part of the reason is that profits are high, and businesses tend to save their profits. Part of the reason is that the insurance system, particularly health insurance, is inadequate, so people have to save extra to allow for emergencies. Part of the reason is that the pension system is inadequate, so people have to save for a worst-case retirement scenario, and since all this saving pushes down returns on assets, the worst case gets even worse.

As I’ve said before, in the simple economics of it, China’s excess saving – including what is implemented through currency manipulation – clearly benefits the US. I’ve touched on reasons why Americans – in the not-so-simple economics of it – may actually be hurt, and my intention is to go into more detail later. When I get a round to it...

McKinnon’s Error

I’ve already made this point, but I’ll take today’s Wall Street Journal Op-Ed by Ronald McKinnon as an occasion to repeat it in different words. According to McKinnon, “…China's motivation for pegging its exchange has been to secure internal monetary stability…” This may indeed be the reason they adopted the peg over a decade ago, but it is clearly not the reason they are maintaining the peg today. If the peg were being used to anchor monetary policy, then monetary policy would still be focused on maintaining the peg. Instead, monetary policy is being pursued independently of the exchange peg, and the peg is being maintained by means of reserve accumulation. If the exchange rate is an anchor, then the rope attached to it is at least several miles long.

As a general rule, exchange rates can be an effective anchor to prevent excessive inflation, because a nation with limited reserves will have to tighten monetary policy in order to maintain a peg in the face of reserve losses. The problem is, it doesn’t work in the other direction. There is no limit on China’s ability to accumulate new reserves, so the peg does not prevent China’s monetary policy from being much tighter than what would be needed to maintain the peg. If China is maintaining monetary stability (and I think they are, but that is debatable), they are doing so by a means other than the exchange peg. The only function of the exchange peg today is to shift demand to the export sector.

Wednesday, April 19, 2006

Capital Returns

If you measure the return on capital by looking at profits (for example, corporate profits in the US national accounts), it has been huge over the last 3 years. But if you measure the return on capital by looking at (real) interest rates, it has been somewhere between small and tiny. What’s going on here?

I really don’t know, but it seems like a critical issue in understanding the world today, so it’s worth thinking about. One possibility is that the equity risk premium has been particularly high. In other words, people expected profits to be high, but they’re still scared to invest in stocks, so they have preferred the ostensibly safe but unimpressive return of bonds. The equity risk premium almost certainly did rise some in 2000-2002 as investors became more timid. But that stock market disaster wasn’t just a matter of becoming timid; investors also reduced their expectations for future profits. In any case, credit spreads today suggest that investors are no longer timid: why would they be willing to invest in junk bonds at not-very-impressive interest rates but not to invest in stocks in companies that are generating huge profits?

Another possibility is that the big profits are seen as a windfall. That is, they weren’t expected, and they aren’t expected to continue. This explanation is probably not consistent with analysts’ earnings estimates, which did anticipate much of the rapid earnings growth of the last 2 years and still call for respectable growth. But perhaps analysts’ earnings estimates don’t represent the view of the general investing public. The “windfall” explanation might be supported by the observation that earnings have been widely dispersed – that is, some industries, such as oil, and some particular companies, such as Microsoft, have experienced extremely high profits that have formed a substantial part of the total. This explanation also might be supported by the observation that corporations have been holding on to large quantities of cash.

A third possibility is that stock prices were already too high relative to the value of the underlying capital, so that, despite high rates of return on capital, the return on stocks was not (and is not expected to be) very high. Certainly, stock returns over the past 3 years have not been nearly as spectacular as the profit statistics would lead one to expect. But if stock prices are so high already, why do we not see more companies issuing stock to take advantage of the high prices? Wouldn’t this be a perfect time to do an IPO, so you can invest the capital and earn some of those huge profits that we see in the statistics?

None of these explanations is very satisfying. Something weird is going on, and I don’t know what it is.

Tuesday, April 18, 2006

A couple of minor points about currency manipulation

Before I continue my series of posts about yuan-dollar manipulation, I want to deal with another couple of minor hydra-heads, which hopefully I can simply incapacitate without generating the usual multiplicative effect.

First is the use of the word “manipulation”. Some people would say that China is not “manipulating” its currency, just passively maintaining a peg to the dollar (or a slowly crawling peg to a basket of currencies that consists primarily of the dollar). This view might seem to cast doubt on the relevance of my assertion that “in a world without market failures, government intervention is always inefficient.” If China were maintaining its peg by means of monetary policy adjustments – the way such pegs are maintained in the textbook models – I would agree that this is not really a case of government intervention or manipulation.

But the reality is that China maintains its peg through direct intervention in the foreign exchange market while pursuing a monetary policy that often runs counter to its exchange rate objective. As a result, the People’s Bank of China accumulates large quantities of US Treasury notes and other US assets. Whether you want to call it “manipulation” is a semantic issue, but clearly the Chinese government is doing something that a purely passive government would not do: it is lending money. Depending on how you look at it, either the Chinese are following an active monetary policy that interferes with their passive exchange rate policy, or they are following an active exchange rate policy in spite of their sensible monetary policy. Either way, it constitutes government intervention. Though I recognize that other semantic conventions may be equally valid, I’ll continue to speak in terms of “currency manipulation”.

The second point is that the Chinese currency manipulation is partly just to compensate for another form of government intervention – capital controls. In other words, since China restricts its citizens from investing abroad, the government has to invest abroad to make up the difference. As I said in another post, a few economists think that, once China’s citizens fully realize their ability to invest abroad (beginning with the recent moves toward relaxation of capital controls), the government’s current currency policy will no longer require intervention. As I also said, those economists are a minority, and I am not one of them. Nonetheless it is important to keep in mind that not all of today’s yuan-dollar manipulation represents “net” government intervention.

Against Liberty

Yesterday was Patriots Day, the day when New England residents commemorate the beginning of the American Revolution, the war “for American liberty.” I don’t want to in any way disparage the contribution of Paul Revere and his fellow revolutionary patriots, but I take issue with the rhetorical justification usually offered for their rebellion. I am against liberty.

I don’t mean to say that we were better off with George III. Quite the contrary: the problem was precisely that the British were availing themselves of too much liberty. For example, British soldiers took the liberty of staying in houses without the consent of the owners. And while the Declaration of Independence pays lip service to “Life, Liberty, and the Pursuit of Happiness,” its list of George’s tyrannies is not so much about excessive restrictions on liberty as about refusal to allow appropriate restrictions, beginning with, “He has refuted his Assent to Laws, the most wholesome and necessary for the public good.”

When we speak of any tyrant – Hitler and Stalin in the 20th century being perhaps better examples than George in the 18th – it is often suggested that this tyrant committed a great evil by depriving people of their liberties. But the greatest evils these tyrants committed were the things they did, not the things they prevented others from doing. The Nazi holocaust, and the Stalinist purges, these were liberties that should not have been permitted.

I don’t deny that liberty can be useful. It is useful to allow people to make decisions for themselves because they have the best information about their own needs and the strongest motivation to take care of those needs. It is useful to allow markets to function freely because free markets are an efficient way to optimize production and distribution. Liberty, in my view, is a necessary evil – not exactly necessary, really, but something often worthy to be tolerated for the benefits it confers rather than for any inherent virtue.

If, however, you want to argue for limited government (and all civilized people, I think, believe that government should have some limitations), it makes little sense to me to argue that limiting government promotes liberty. To limit government is to restrict the government’s liberty. Limiting government may in many cases have the beneficial side effect of increasing economic efficiency, but that is not the best reason to advocate it. The best reason is that limitations on government take away the government’s liberty to do horrible things.

About About

Apparently About.com is not a reliable source. You can check this link to see if they have corrected the error, but the following is exactly what I cut and pasted from the linked page:

“The unemployment statistics and national unemployment rate do not include workers whose unemployment compensation benefits have expired or those who have given up looking for a job.”

...and later on:

“The unemployment statistics don't including people no longer collecting unemployment benefits or those who have given up looking for work.”

Everyone who has studied labor economics or Bureau of Labor Statistics methodology knows that the part about unemployment benefits is wrong. The unemployment rate does not depend on who is getting benefits. The unemployment rate comes from the Current Population Survey, and workers whose unemployment compensation benefits have expired are still counted as long as they meet the BLS definition of “unemployed”: “Persons are classified as unemployed if they do not have a job, have actively looked for work in the prior 4 weeks, and are currently available for work.” (You can dig deeper on the Web site to find a more precise definition and description of the methodology, but this is the gist of it.)

It’s important that many people have given up looking for jobs, so they are not counted as unemployed (and also not receiving benefits). Also, many whose benefits have expired have taken part-time jobs and therefore are also not counted as unemployed. And many people are still looking for jobs but not “actively”, and those people are also not counted. And many may be looking actively but have made other commitments that prevent them from starting immediately, and those also are not counted. But it has nothing directly to do with whether you receive unemployment benefits.

Monday, April 17, 2006

Currency Manipulation, continued

I still haven’t bothered to solve my currency manipulation model, but I’m pretty confident in what it would show: in a world without market failure, attacking your own currency hurts your own country more than it helps your trading partners. And there was never any question that the manipulating country is the loser, and the trading partner is the winner. But when we look at the US and China, it’s quite clear that most of the support for currency manipulation is coming from the “loser”, China, while most of the opposition is coming from the “winner”, the US. Why?

Part of the answer is undoubtedly political. On both sides of the Pacific, there are both winners and losers within the population, and it happens that both the Chinese winners and the American losers are very important politically. For anyone who remembers the 2004 Presidential election (or anyone who studied the state-by-state results of the previous 10 Presidential elections), I can make this point about the US in just one word: Ohio. Although I know less about Chinese politics, I get the impression that marginal workers in the manufacturing sector are thought to be a potentially dangerous group.

But I really don’t think that’s the whole story. The fact is, we don’t live in a world without market failure. Human irrationality, sticky prices and wages, time to build, path-dependence, monopoly and monopsony power, pre-existing government distortions, externalities, missing markets, not to mention all the examples of market failure that I’ve forgotten – these things are not only present but, in my opinion, potentially important in understanding the US economic relationship with China. Moreover, the distribution issue discussed in the last paragraph is not just a political one: the US population, in aggregate, may benefit from China’s currency manipulation, but that doesn’t mean that the typical American benefits; if the benefit is sufficiently concentrated within the population, then the typical American can end up making a sacrifice for the benefit of the average American. (If you take a look at recent income distribution statistics, you may notice that the average American has been doing very well over the past few years, but the typical American – that is, the median American – has been losing ground.)

Trying to blog about the Yuan issue, I feel like Hercules battling the hydra. Every time I try to simplify the issue, it grows two more heads. I’ll have to deal with the latest heads in future posts.

Update: Another point regarding the “average American”: What conclusion you reach may depend on what quantity you are averaging. If you take average income, then, in the absence of market failure, the weak yuan policy clearly helps the US. But if the benefits go disproportionately to the rich while the costs fall disproportionately on the poor, then average welfare might be reduced. Because of diminishing marginal utility, a given amount of additional income is worth more to the poor than to the rich.

Sunday, April 16, 2006

The “Simple” Economics of Currency Manipulation

I had forgotten how complicated economics becomes when you try to do it rigorously.

I want to explain why, in a “simple” world – meaning one without market failures – currency manipulation is inefficient. The easy answer is that, in a world without market failures, government intervention is always inefficient. But that answer is unsatisfying. (Some might say that real currency manipulation is impossible in a world without market failures, because prices will adjust to bring real exchange rates back to a market level. However, it is clearly possible for governments to accumulate reserve assets on which they will earn income, and this process must have real effects.) The more detailed answer is anything but simple.

Why is currency manipulation bad? Because it distorts the intertemporal terms of trade. Why is distortion of the intertemporal terms of trade bad? Two reasons. First, it distorts consumption decisions by reducing consumption when the currency is weak and increasing consumption when the currency is strong. Second, it distorts production decisions by shifting production into the tradables sector when the currency is weak and into the nontradables sector when the currency is strong. So, in a country whose government is attacking its own currency, the tradables sector will operate inefficiently at the margin, while in its trading partner the nontradables sector will operate inefficiently at the margin. Later, when the manipulation stops, the situation will reverse itself. In the end, total production could have been increased if the non-manipulating country had originally produced more tradables.

That explanation is already complicated, and the prose is somewhat ragged around the edges. The story does seem to fit well with the situation between the US and China today. In the US, nontradable industries like construction and health care are struggling to find workers and materials, obviously not being very efficient at the margin, while tradable industries like manufacturing are leaving both workers and physical capacity idle, apparently foregoing increases in production that could be very efficient. I’m less clear on what’s happening in China, but I get the impression that manufacturing is expanding at an unhealthy pace, while the health care industry is producing less than what would be healthy for the typical Chinese citizen.

I tried to put this explanation into a rigorous form, using the simplest possible assumptions in a two-country, two-sector, two-period model, to show that the manipulating country loses more than the trading partner gains. But there’s just too damn many equations, and it’s not worth the trouble of solving them. I wanted to make what I thought was a simple point, but it seems to require a whole research project.

Saturday, April 15, 2006

Monetary Policy, Not Immigration Policy

The following quote from Paul Craig Roberts (taken from a piece quoted in a comment to this Economist’s View post) typifies a common point of view that I think has got things completely backwards:

“Job growth over the last five years is the weakest on record. The US economy came up more than 7 million jobs short of keeping up with population growth. That's one good reason for controlling immigration. An economy that cannot keep up with population growth should not be boosting population with heavy rates of legal and illegal immigration.”

First of all, many economists believe that the failure of job growth is a supply problem rather than a demand problem. Certainly part of the reason that job growth has not kept up with population growth is that the fraction of the population in their prime working years has declined. And part of the reason is that young people are choosing to delay working in order to become better educated. And part of the reason may be that people (now including men as well as women) are beginning to prefer caring for their own children to working. To the extent that it is a supply problem, the slow job growth could be taken as an argument for increasing rather than decreasing immigration.

Personally, I don’t agree that the main problem is on the supply side. But many at the Fed do think so, and that’s just where the problem is. As long as the Fed believes the labor market is approaching a capacity constraint, reducing immigration can only make things worse.

What would happen if we were to reduce immigration? Some of the businesses that now hire immigrants would have to hire Americans. In itself, that might be a good thing, but the story doesn’t end there. As businesses hire more Americans, the unemployment rate would fall, and the Fed would pursue its tightening policy farther than it currently intends. The Fed’s tightening would result in a weaker economy, which would cause other businesses to lay off Americans. The net effect on employment of Americans would be close to zero (and the direction of the net effect is unclear).

If you want to argue that immigration reduces the real wages of Americans, there is certainly an argument to be made, but I’m not going to get into that here. To argue that immigration is bad because the economy already isn’t creating enough jobs is to misunderstand macroeconomic policy.

Friday, April 14, 2006

China’s currency: what’s news?

From the “What’s News” column of Saturday’s Wall Street Journal: “China’s decision to liberalize its foreign-currency regime is unlikely to result immediately in a strengthening of the yuan. (Article on Page A4)”

And this is news? Am I missing something, or should the story have been, “The effect of China’s relaxation of capital controls has been widely misunderstood by potential Wall Street Journal readers.”?

The article is quite clear about what China did: “China’s central bank announced measures that will make it easier for individuals and companies to buy foreign currency – and then for the first time to invest those funds overseas in stocks and bonds through banks and brokerage firms.” The substance had already been reported in Friday’s “What’s News” column (along with any number of other places in the financial press): “China will allow companies and individuals to make significant investments abroad for the first time…”

In other words, people who previously had to hold their assets in yuan-denominated form will now be allowed to sell those yuan. (I know that’s an oversimplification, but that’s the gist of it.) OK, here’s a quiz: what happens to the price of something when people sell more of it? Does the price go up? (It’s been a few years since I was in school. Maybe I’ve missed some of the latest thinking on this topic.)

Assuming economics has not been completely turned on its head in the last 12 years (and that the yuan is not a Giffen good), it seems to me that the relaxation of capital controls cannot result in a strengthening of the yuan. What it will do, of course, is reduce the required amount of intervention by the Chinese to support the dollar’s current exchange rate against the yuan. Think of it as partially privatizing the job of supporting the dollar.

What the Chinese apparently hope is that, eventually, investment abroad by Chinese individuals and businesses will become so popular that the job of supporting the dollar (or other foreign currencies) can be “fully privatized.” At that point, the intervention will no longer be necessary, the currency can be made fully convertible, and nobody can continue to accuse the Chinese of manipulation. Some economists think that might actually happen.

Well, a few economists think so, anyway. Most, however, think that the Chinese will have to allow the yuan to appreciate significantly before they can stop their intervention. It is unclear whether yesterday’s action will hasten or delay such a change.

Not in Kansas any more

After I adopted the name (but before I started this blog), I did a blog search and discovered that there is another “knzn” in the blogosphere.His interpretation of the name is apparently geographic and has nothing to do with macroeconomics.Since his blog entries appear to have ended more than a year ago, and his subject matter is quite different, I’m hopeful that there will be no confusion.